Your ‘made in America portfolio’ isn’t what it seems

Much like the U.S. itself, many domestic companies have international reach

For most Americans, there’s nothing better than waving the flag and showing their patriotism while celebrating the Fourth of July.

But there may be nothing better for their investment portfolio all year long than celebrating America by investing in domestic-equity funds.

That’s not a statement on the U.S. stock market so much as it is a comment on how “domestic” funds aren’t nearly as red, white and blue as their shareholders expect.

It doesn’t take a patriot to acknowledge that — despite its many faults — the U.S. stock market is the world’s best in terms of regulation, consistency and accuracy of numbers. Performance hasn’t been too shabby either, with an average annualized gain over the last five years of more than 19.5% for the Standard & Poor’s 500 index
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.

The benefits of diversification are undeniable, and anyone who lived through the bear market of 2000 or the financial crisis of 2008 knows that being “all-domestic” can mean getting swept out with the tide.

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But the underlying truth is that investors are far more diversified simply by purchasing domestic mutual funds than they might recognize, so much so that the category of “domestic fund” may be more misnomer than accurate description.

“Investors are unaware of how much international exposure they have in a domestic fund, because it’s not easily teased out in anyone’s portfolio, but it’s more than they would expect,” said Michael Foss, manager of Brown Advisory Equity-Income
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. “You can’t get that international exposure in all sectors or industries, but you start with more than you would expect.”

For starters, the agencies that rate and classify funds leave plenty of wiggle room for domestic funds to wander. Lipper Inc., for example, allows domestic funds to have up to 25% of their portfolio in non-US names before they would get bumped into the “global equity” category (over 75% in non-US names pushes a fund into the international equity classifications).

But even the companies that qualify as U.S. stocks do a significant portion of business overseas. Think, for example, of a fund that invests in Coca-Cola
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, an All-American brand name that was described in the mid-1990s by its chairman as being akin to a global mutual fund because it had operations spread around the world.

Sam McBride, an analyst with the Nashville-based research firm New Constructs, noted that of the top five holdings in the SPDR S&P 500 ETF
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— all of which the ratings agencies would say are “domestic stocks” — only Microsoft
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earns less than half of its revenue internationally (and Microsoft still gets a major chunk of its revenues from foreign sales/operations).

As investors might expect, the effect is reduced when the companies are smaller, but McBride noted that the top five holdings in the iShares S&P SmallCap 600 Index ETF
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take in an average of 17% of revenues from abroad.

And that’s before a fund manager ever buys American Depository Receipts (ADRs), which allow foreign companies to trade on the U.S. exchanges, de facto turning them into “domestic” issues, at the very least assuring the investor of getting the U.S. accounting standards.

“I strongly believe that one can get full international exposure by investing in US stocks or funds which focus on U.S. based stocks,” said John Barr, manager of Needham Aggressive Growth
NEAGX, -0.85%
. “At least three-quarters of our companies, independent of market cap, derive significant revenue from international operations. By significant, I estimate 30 to 50 percent or more of revenue.”

None of it discounts the need to invest on an international or global scale, but instead the point is that an investor looking to make a 25% to 33% portfolio allocation to international markets may already have that kind of exposure without leaving home.

They may be lacking in exposure to certain industries — financials, utilities and retailing, for examples, are sectors where even the major players may not cross international borders — but that would also suggest that the right way to build a portfolio would be to use specialized international funds that play to those niches.

Going forward, however, money managers and ratings agencies may look to reclassify funds, reflecting the idea that large businesses in most industries function in a global marketplace, no matter where their securities trade.

“The advantage of investing in domestic companies is that an investor can better understand them,” Barr said. “They know or can meet people who work there to understand the culture. We are also protected by and have a better understanding of U.S. law. We really have no idea what’s going on in China, unless we’d lived there for a long time. It’s much better to have our CEOs invest in Chinese operations than for us to invest in Chinese stocks.”

So celebrate America but, if you do it in your portfolio because a USA-centric approach appeals to you, recognize that you’re moving well beyond domestic borders whether you planned to go there or not.

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